Ariel Investments Portfolio Manager David Maley details his investment philosophy as portfolio manager of Ariel Discovery Fund.
Investing in small-cap stocks is more risky and volatile than investing in large-cap stocks. The intrinsic value of the stocks in which Ariel Discovery Fund invests may never be recognized by the broader market. Past performance does not guarantee future results.
Question: You describe part of your investing philosophy as being “benchmark agnostic.” Can you explain what you mean by this?
Answer: Although we measure ourselves against the Russell 2000 Value Index because we think it is most comparable to the stocks that we invest in, we truly are benchmark agnostic overall. This means we look at each investment on its own merits, stock by stock. We will often use the term “bottom-up investing,” to describe this approach. We do not try to match the sector weights of our benchmark. In fact, we try not to even think about benchmarks in the short term. The benchmark serves as a tool to help us compare our own long-term performance against respected peers and others who invest similarly to us.
Question: What is deep value investing, and how does it differ from the other Ariel funds?
Answer: Deep value investing can mean different things to different people. My approach to deep value involves seeking to invest with a margin of safety. While investing with a margin of safety cannot eliminate risk1, I want to invest in stocks at a price so low relative to intrinsic value that even if things go wrong with the company, we can still have a successful investment. In practice, this usually means buying stocks at a low price-to-net-asset value (or price-to-book value).
The biggest difference between my approach and the approach of the rest of Ariel’s domestic funds is this focus on assets. While our traditional value approach looks for quality companies with predictable cash flows and tries to buy them when they are on sale, I look for safety in the assets of the company and then anticipate the fundamentals and operations of the company will yield unexpected upside.
Question: What role does Ken Kuhrt play as your portfolio manager on Ariel Discovery Fund?
Answer: I am the lead portfolio manager, so ultimately the final decisions rest with me. However, Ken, as portfolio manager, works very closely with me. His office is right next to mine, and we will typically talk five, ten, maybe twenty times a day. While we tend to agree most of the time, one of the things I value in Ken is his willingness to disagree with me and challenge my assumptions. This is why his input is very important and why I will always take it seriously. It is good to have someone who is not just a “yes” person. He often plays the devil’s advocate role, as do all the other analysts. Sometimes he may change my mind and sometimes I will stick with what I originally thought. Ultimately if there is a decision that has to be made, it rests with me.
Question: What criteria do you consider when adding a new stock to Ariel Discovery Fund?
Answer: : There are four things we look for:
- First is size. We will only look at companies that are $2 billion or under in market cap. Our sweet spot tends to be in the range of $200 million to $1 billion. Those are stocks that are small enough to be off the radar of most investors.
- Second, we want companies that trade at a low price-to-book ratio.
- Third, we want companies that have great balance sheets. Most of our companies have little or no debt, and most have significant excess cash. We think that helps toward the margin of safety that we seek.
- Fourth, we want companies where there is significant inside ownership and strong corporate governance. I believe that incentives drive behavior. We want management and the boards of our companies to have skin in the game and to have incentives in line with our interests and those of our shareholders.
Question: What other methods of valuation do you use?
Answer: We think of ourselves as using a valuation toolbox. Once we identify companies with low price-to-book ratios and good balance sheets, we then step back and say: How should we value this company? Should we value it purely on its assets? Should we value it on its cash flows and earnings? Or is some combination or sum of the parts analysis the best tool? We also use price-to-earnings, EV-to-EBITDA, discounted cash flow analysis—all the same tools that are used in our traditional value products, but we utilize them only when applicable.
Question: What is the difference between Ariel Discovery Fund and Ariel Fund?
Answer: There are two main differences:
- One is cap size. Ariel Discovery Fund considers stocks $2 billion and under; and Ariel Fund invests in companies between $1 billion and $7.5 billion.
- The other is the deep value approach, which I use, versus the traditional value approach, which John Rogers applies when managing Ariel Fund. John looks for high-quality companies with predictable cash flows, predictable earnings and earnings growth. He wants to buy those stocks when there is some kind of short-term cloud and they are on sale. On the other hand, I look to buy stocks that are trading on a relatively low price-to-book basis with a perceived margin of safety built into the price.
Question: What is the holdings overlap between Ariel Discovery Fund and Ariel Fund?
Answer: It is generally less than 10%. These funds tend to act differently. When we find a name that fits both, it will typically be a stock that trades at a low price-to-book value and also has reasonably predictable cash flows. It is the best of both worlds, and that might be a stock that makes sense for me and for John Rogers and his team.
Question: Is your method of investing riskier than John’s because it is smaller cap companies?
Answer: There is a perception that the smaller you are, the riskier. However, our approach is based on seeking to reduce risk by buying quality assets at a very discounted price.
Question: Would you describe your fund as more or less concentrated than other Ariel funds?
Answer: Our concentration is very similar to Ariel Fund and Ariel Appreciation Fund. We tend to own between 35 and 40 stocks. Ariel Focus Fund owns fewer, and Ariel International Fund and Ariel Global Fund own a little bit more.
Question: Does it take longer to complete “buy” and “sell” orders for a small-cap fund such as Ariel Discovery Fund? If so, how does this affect fund performance?
Answer: It can take longer, but it doesn’t always. Smaller stocks tend to be less liquid, but we actually think that can work to our advantage. For instance, sometimes we will buy stocks when they are on sale in the marketplace, or sell or lighten up on stocks when there is enthusiasm behind them, so we try to be a provider of liquidity. Also, at times we have been able to buy stocks that have had a tough time in the marketplace near year end when they are sold for tax purposes. That can create a depressed stock price, which hopefully allows us to get the margin of safety we are looking for.
Question: How do you know when to sell a stock and when to trim position size?
Answer: We typically sell a stock in its entirety if we believe the investment thesis has significantly changed, that management has done something to jeopardize the balance sheet, or when something is truly wrong. Normally if a stock is working and it is going up toward our estimate of fair value, we will trim. For a stock that is working, it is rare we would sell it entirely at one point.
Question: What makes a company’s balance sheet attractive to you?
Answer: The first thing would be lack of debt. Second would be excess cash on the balance sheet. Beyond that, it is the quality of the assets on the balance sheet and how certain those are, or how understated those might be.
Question: Why is the turnover rate in Ariel Discovery Fund, which was 42.0% as of the quarter ended June 30, 2018, so high? Isn't this turnover inconsistent with Ariel's investment philosophy? Could you decrease the expenses of Ariel Discovery Fund by decreasing the turnover rate?
Answer: While it may appear inconsistent with Ariel’s philosophy on the surface, it is first important to distinguish trading around a stock versus how long we hold a stock overall. Our turnover rate tends to be high because we take advantage of moves in our stocks to trade around positions when the market affords us that opportunity. However, our turnover in names tends to be very low, generally well under 20%.
Our focus is very long term. We buy and hold our stocks with a 3- to 5-year time horizon or longer; however, we may trade around them. We believe that taking advantage of spikes and dips, which can happen in our stocks, can be very beneficial for our shareholders. For instance, last year Erickson Inc. ran into the mid-to-high $20s, so we sold some stock there, actually quite a bit—lately, we have been buying it back this year in the teens. In the long run, we believe we will be much better off to have sold shares and then bought some back cheaper. That is what we try to do while keeping the stock as a core position.
Question: Where do mergers and acquisitions play into your portfolio? Are you looking for companies that could be taken over?
Answer: We never buy a stock just because we think it is likely to be taken over. However because these companies tend to have great niches with good balance sheets and excess cash, their enterprise value is typically less than their market cap, which makes them good takeover candidates. They are bite-size nuggets for bigger companies. I cannot predict if and when takeovers may occur, but we think there are a lot of candidates.
Question: Where do you see the market headed? Do you advise shareholders to stay put or pull their money out of the stock market? I am looking at the long term. What is your advice?
Answer: Over time I believe our economy and our markets should do well, but in terms of trying to predict it in the short or even intermediate term, I would not even want to make a guess. As a long-term investor, I would advise similar minded shareholders to stay the course. I think the best idea is to continually dollar-cost average into the market over time, whether it is in your 401(k), excess funds, or whatever you have. When the market dips you are actually buying at a better price.
Question: How is your portfolio positioning unique?
Answer: One thing that is unique and attractive about Ariel Discovery Fund is its tendency to be fairly uncorrelated with the market. So when we talk about underperforming, six months to us is a drop in the bucket, time-wise. We prefer to focus on long-term returns, seeking a margin of safety, and being truly independent thinkers. We believe over time this could generate excess returns for our shareholders.
Question: Are there many managers that share your small-cap deep value investing approach? Is this a unique category?
Answer: There are other managers who also apply a deep value approach. However, we think we are very unique in being at the small end of small cap, being concentrated, and using this asset-based approach on companies with very strong balance sheets. Many other deep value investors will buy broken companies that are distressed, feeling that some of them are going to go bankrupt, believing that is OK because they are hoping to hit some homeruns. In contrast, our deep value approach purposely applies a conservative style to an area of the market that is generally considered high risk.
Question: What or who influenced you most as an investor? What brought you to Ariel?
Answer: I would say I am heavily influenced by the teachings of Graham and Dodd, who are considered the fathers of value investing. Also, investor Seth Klarman wrote a book in 1991 called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. Klarman’s book hugely influenced the practical application of the teachings of Graham and Dodd. I insist that every new analyst who works with me read it. That book influenced me more than anything else I have read about investing. I was about 30 years old when I read it and luckily the book was much more accessible at that time. It was only published once and today a copy of it can go for $3,000.
To understand what brought me to Ariel, one must first appreciate my long history with the firm. When I started my micro-cap limited partnership using the same style that we use now for Ariel Discovery Fund, Ariel was an initial investor. After nearly 7 years of being on my own, I brought that portfolio to Ariel and we launched it as the Ariel Micro-Cap Value Product in 2002. Then in 2011, we were able to launch Ariel Discovery Fund and bring that same disciplined approach to our mutual fund shareholders.
1Attempting to purchase with a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations on our part, declining fundamentals or external forces.
This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Click here to view the Glossary for definitions of terms used.
The particular stock mentioned was, as of the date of this communication, and may currently be a portfolio holding in Ariel Discovery Fund. Click here for the schedule of holdings Ariel Discovery Fund. Any holdings mentioned do not constitute all holdings in the Fund. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel Discovery Fund.
The Russell 2000® Value Index measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights.
by David Maley: